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Oligopoly

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Oligopoly

Imagine you have a company, and it is doing great. You are in an industry where four other companies have a similar market share to yours. There are not many other companies out there that produce what you’re producing, and those that are, are relatively small. To what extent do you think the behaviour of the other four companies will impact the way you price your goods and the amount of output you choose? Would you choose to collude with them and set prices or continue competing if it was feasible?

This is what oligopoly is all about. In this explanation, you will learn everything you need to know about oligopoly, how firms behave in an oligopolistic market, and whether they always collude or compete.

What is oligopoly?

Oligopoly occurs in industries where few but large leading firms dominate the market. Firms that are part of an oligopolistic market structure can’t prevent other firms from gaining significant dominance in the market. However, as only a few firms have a significant share of the market, each firm’s behaviour can have an impact on the other.

There must be a lower limit of two firms for a market structure to be considered oligopolistic, but there’s no upper limit to how many firms are in the market. It is essential that there are a few and all of them combined have a significant share of the market, which is measured by the concentration ratio.

An oligopoly is a market structure where a few large firms dominate the market.

To learn more about other types of markets as well as how to calculate concentration ratios check our explanation on Market Structures.

The concentration ratio is a tool that measures the market share of the leading companies in an industry. You could have maybe five firms, seven, or even ten. How do you know if it’s an oligopolistic market structure? You have to look at the concentration ratio of the largest firms. If the most dominant firms have a combined concentration ratio of more than 50%, that market is considered an oligopoly. That is to say, oligopoly is about the dominant firms’ market power in a given industry.

You can usually find typical examples of oligopolistic market structures in oil companies, supermarket chains, and the pharmaceutical industry.

When companies gain high collective market power, they can create barriers that make it significantly hard for other firms to enter the market. Additionally, as few firms have a large part of the market share, they can influence the prices in a way that harms consumers and the general welfare of society.

Characteristics of oligopoly

These are the most important characteristics of oligopoly that you should know about:

Firms are interdependent

As there are a few firms that have a relatively large portion of the market share, one firm’s action impacts other firms. This means that firms are interdependent. There are two main methods through which a firm can influence the actions of other firms: by setting its price and output.

Product differentiation

When firms don’t compete in terms of prices, they compete by differentiating their products. Examples of this include the automotive market, where one producer might add specific features that would help them acquire more customers. Although the car price might be the same, they are differentiated in terms of the features they have.

High barriers to entry

The market share acquired by the top companies in an industry becomes an obstacle for new companies to enter the market. The companies in the market use several strategies to keep other companies from entering the market. For instance, if firms collude, they choose the prices at a point where new companies can’t sustain them. Other factors such as patents, expensive technology, and heavy advertising also challenge new entrants to compete.

Uncertainty

While companies in an oligopoly have perfect knowledge of their own business operations, they do not have complete information about other firms. Although firms are interdependent because they must consider other firms’ strategies, they are independent when choosing their own strategy. This brings uncertainty to the market.

Price setters

Oligopolies engage in the practice of price-fixing. Instead of relying on the market price (dictated by supply and demand), firms set prices collectively and maximise their profits. Another strategy is to follow a recognised price leader; if the leader increases the price, the others will follow suit.

Collusive vs non-collusive oligopoly

Collusive oligopoly occurs when firms form an agreement to jointly set prices and choose the production level at which they can maximise their profits.

Not all firms face the same production costs, so how does it work for firms with higher costs? Firms that might not be as productive in the market benefit from the agreement, as the higher price helps them stay in business. Other firms enjoy abnormal profit and keep problems that come with the competition out of their head. It’s a win-win for both.

Formal collusive agreements between firms are known as cartels. The only difference between collusion and monopoly is the number of firms, and everything else is the same. Collusion enables firms to increase prices and gain abnormal profits. One of the most famous cartels is the Organization of the Petroleum Exporting Countries (OPEC), which has significant influence over oil prices worldwide.

Cartels are the formal collusive agreements between firms.

Collusive oligopoly and cartel agreements are significantly harmful to consumers and the general welfare of society. Governments closely monitor these agreements and prevent them from taking place via anti-competitive laws.

However, when collusion is in the benefit and interest of the society, it is known as cooperation, which is legal and encouraged by governments. Cooperation does not involve setting prices to maximise profit. It instead involves actions such as improving health in a particular sector or increasing standards of labour.

Cooperation is a legal form of collusion for the benefit and interest of society.

Non-collusive oligopoly involves a competitive type of oligopoly where firms do not form agreements with one another. Rather, they choose to compete with one another in an oligopolistic market structure.

Firms will still depend on other firms’ actions as they share a large portion of the market, but firms are independent in their strategies. As there is no formal agreement, firms will always be uncertain how other firms in an oligopoly will react when they apply new strategies.

Simply put, in a non-collusive oligopoly, you have firms independently choosing their strategies whilst there is still interdependence amongst them.

The kinked demand curve

The dynamics in a non-collusive oligopoly can be illustrated by using the kinked demand curve. The kinked demand curve shows the possible reactions of other firms to one firm’s strategies. Additionally, the kinked demand curve helps show why firms don’t change prices in a non-collusive oligopoly.

oligopoly kinked demand curve studysmarterFigure 2. The kinked demand curve, StudySmarter Original

Assume that the firm is in an oligopolistic market structure; it shares the market with a few other firms. As a result, it should be cautious of its next move. The firm is considering changing its price to increase profit further.

Figure 1 illustrates what happens to the firm’s output when it decides to increase its price. The firm is faced with elastic demand at P1, and an increase in price to P2 leads to a much higher drop in the output demanded compared to if the firm was faced with inelastic demand.

The firm then considers decreasing the price, but it knows that other firms will also decrease their prices. What do you think would happen if the firm decreased the price from P1 to P3?

As other firms will also reduce their prices, the quantity demanded will respond by very little compared to the price increase. How?

Other firms reacted by decreasing their prices too, which caused all the firms to share the total market share gained from the decrease in price amongst themselves. Therefore, none of them profits as much. That’s why there’s no incentive for firms to change their prices in a non-collusive oligopoly.

Price leadership, price agreements, and price wars in oligopoly

Price leadership, price agreements, and price wars often occur in oligopolies. Let’s study each of them independently.

Price leadership

Price leadership involves having a firm leading the market in terms of the pricing strategy and other firms following by applying the same prices. As cartel agreements are, in the majority of the cases, illegal, firms in an oligopolistic market look for other ways to maintain their abnormal profits, and price leadership is one of the ways.

Price agreements

This involves price agreements between firms and their customers or suppliers. This is especially helpful in case there is turmoil in the market as it allows firms to adjust their strategies better and address the challenges accordingly.

Price wars

Price wars in an oligopoly are very common. Price wars happen when a firm tries to either take its competitors out of business or prevent new ones from entering the market. When a firm faces low costs, it has the ability to decrease the prices. However, other firms have different cost functions and can't sustain the price decrease. This results in them having to leave the market.

Advantages and disadvantages of oligopoly

Let’s explore some of the advantages and disadvantages of oligopoly for both firms and customers.

Advantages of oligopoly

Firstly, firms can gain extreme profits in some cases as they face little to no competition. This allows firms to charge higher prices and expand their margins. As a result, firms in an oligopoly have more money to spend on research and development than they would otherwise in a competitive market. The research and development benefit consumers they develop new drugs, new products that will solve problems, etc.

Other benefits come from product differentiation, which is a major part of an oligopolistic market structure. When firms don't compete in terms of prices, they constantly look to make their product different and better to acquire more customers. As a customer, you will always have firms trying to find ways to give you better products.

Disadvantages of oligopoly

An oligopolistic market also has many disadvantages. Such disadvantages include high prices, which often harm consumers, especially those incapable of paying for these high prices.

Additionally, having a high market concentration amongst some firms provides very limited choices to consumers as the firms may be disincentivised to innovate. Consumers only have a few firms to choose from.

Another disadvantage comes from high barriers to entering a certain market, preventing new firms from joining and offering their products, thereby increasing competition and social welfare.

Oligopoly - Key takeaways

  • Oligopoly occurs in industries where few but large firms dominate the market.
  • The characteristics of oligopoly include interdependence, product differentiation, high barriers to entry, uncertainty, price setters.
  • The concentration ratio is a tool that measures the market share leading companies have in an industry.
  • Collusive oligopoly occurs when firms form an agreement to jointly set prices and choose the production level at which they can maximise their profits

  • Non-collusive oligopoly involves a competitive type of oligopoly where firms do not form agreements with one another. Rather, they choose to compete with one another.

  • The dynamics within a non-collusive oligopoly can be illustrated by using the kinked demand curve.

  • Price leadership involves having a firm leading the market in terms of the pricing strategy and other firms following by applying the same prices.

  • Price wars in an oligopoly happen when a firm tries to either take its competitors out of business or prevent new ones from entering the market.

Frequently Asked Questions about Oligopoly

Price wars in an oligopoly are very common. Price wars happen when a firm tries to either take its competitors out of business or prevent new ones from entering the market. When a firm faces low costs, it has the ability to decrease the prices.

Oligopoly occurs in industries where few but large leading firms dominate the market. Firms that are part of an oligopolistic market structure can't prevent other firms from gaining significant dominance over the market. However, as few firms have a significant share of the market, the behaviour of each firm can have an impact on the other. 

  • Firms are interdependent
  • Product differentiation
  • High barriers to entry
  • Uncertainty

Final Oligopoly Quiz

Question

Define oligopoly.

Show answer

Answer

Oligopoly occurs in industries where few but large leading firms dominate the market.

Show question

Question

Can firms in an oligopolistic market structure prevent other firms from gaining a significant share over the market?

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Answer

Firms that are part of an oligopolistic market structure can't prevent other firms from gaining significant dominance over the market. However, as few firms have a significant share of the market, the behavior of each firm is capable of having an impact on the other.

Show question

Question

What's the lower limit for a market to be considered oligopoly?

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Answer

There must be a lower limit of two firms for a market structure to be considered oligopolistic.

Show question

Question

Is there any upper limit as to how many firms can participate in oligopoly?

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Answer

There's no upper limit to how many firms are in the market. It is essential that there are few and all of them combined have a significant share of the market, which is measured by the concentration ratio.

Show question

Question

What is the concentration ratio?

Show answer

Answer

The concentration ratio is a tool that measures the market share leading companies have in an industry

Show question

Question

Mention examples of oligopoly.

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Answer

Usually oil companies, supermarket chains, the pharmaceutical industry.

Show question

Question

What does it mean that firms are interdependent?

Show answer

Answer

As there are a few firms that have a relatively large portion of the market share, one firm's action impacts other firms. This means that firms are interdependent with one another.

Show question

Question

What does product differentiation mean?

Show answer

Answer

When firms don't compete in terms of prices, they compete by differentiating their products. Examples of this include the automotive market, where one producer might add specific features that would help them acquire more customers. 

Show question

Question

Explain high barriers as a characteristic of oligopoly.

Show answer

Answer

The market share acquired by the top companies in an industry becomes an obstacle for new companies to enter the market. They use several strategies to keep other companies from entering the market. For instance, if firms collude, they choose the price at a point where new companies can't sustain them

Show question

Question

Explain uncertainty as a characteristic of oligopoly.

Show answer

Answer

While companies in an oligopoly have perfect knowledge of their own business operations, they do not have complete information about other firms. Although firms are interdependent because they must consider other firms' strategies, they are independent when choosing their own strategy. This brings uncertainty to the market.

Show question

Question

Mention the key characteristics of oligopoly.

Show answer

Answer

  • Firms are interdependent
  • Product differentiation 
  • High barriers to entry
  • Uncertainty
  • Price-setters

Show question

Question

Define collusive oligopoly.

Show answer

Answer

Collusive oligopoly occurs when firms form an agreement to jointly set prices and choose the production level at which they can maximise their profits.

Show question

Question

Define non-collusive oligopoly.

Show answer

Answer

Non-collusive oligopoly involves a competitive type of oligopoly where firms do not form agreements with one another rather than compete in an oligopolistic market structure. 

Show question

Question

What are cartel agreements?

Show answer

Answer

Are official agreement of collusion in the market.

Show question

Question

What's the kinked demand curve?

Show answer

Answer

The kinked demand curve shows the possible reactions of other firms to one firm's strategies. Additionally, the kinked demand curve helps show why firms don't change prices in a non-collusive oligopoly.

Show question

Question

What is price leadership?

Show answer

Answer

Price leadership involves having a firm leading the market in terms of the pricing strategy and other firms following by applying the same prices.

Show question

Question

What are price wars?

Show answer

Answer

Price wars in an oligopoly are very common. Price wars happen when a firm tries to either take its competitors out of business or prevent new ones from entering the market. When a firm faces low costs, it has the ability to decrease the prices.

Show question

Question

The demand curve of oligopoly market structure is ___________


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Answer

kinked

Show question

Question

Oligopoly occurs in industries where ___________ firms dominate the market.

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Answer

few large 

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Question

The characteristics of oligopoly include interdependence, ___________, high barriers to entry, uncertainty, and ___________. 

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Answer

product differentiation, price setters 

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Question

Firms in oligopoly market structure are price takers. 

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Answer

True

Show question

Question

___________ occurs when firms form an agreement to jointly set prices and choose the production level at which they can maximise their profits. 



Show answer

Answer

Collusive oligopoly

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Question

Collusive oligopoly and cartel agreements are significantly harmful to consumers and the general welfare of society. 

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Answer

True

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Question

The concentration ratio is a tool that measures the market share of the ___________ in an industry. 

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Answer

leading companies 

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Question

___________ involves having a firm leading the market in terms of the pricing strategy and other firms following by applying the same prices. 


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Answer

Price leadership 

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Question

Price wars are not very common in oligopoly. 

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Answer

True

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Question

What is not an advantage of oligopoly?

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Answer

Firms can gain extreme profits

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Question

Having a high market concentration amongst some firms provides ___________ product choices to consumers.


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Answer

few

Show question

Question

Product differentiation is a benefit of oligopoly. 


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Answer

True

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Question

Formal collusive agreements between firms are known as ___________.  

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Answer

cartels 

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Question

Price-fixing is a common practice among oligopolies. 

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Answer

True

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